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Trading with the McClellan Oscillator

Bryan Noble, TraderNoble.com

Most traders know that we tend to be better in interpreting the left-hand side of charts, but it is the right-hand side that normally gives us problems. As we approach the traditionally weakest six weeks of trading in the year, from mid September to end October, coupled with the presidential election on November 8, I would like to share with you how you can benefit by buying into any sharp sell-off over this coming time frame.

The McClellan Oscillator (MO), one of the least known technical indicators, basically measures the internal readings of the US stock market. If the MO prints greater than +250 the stock market is overbought, while below -250 is an indication of an oversold market. This indicator, likes most technical indicators that I follow, works best on the downside. Below is a more detailed discussion on the McClellan Oscillator.

The McClellan Oscillator was created in 1969 and is recognised by technical analysts as the essential tool for measuring acceleration in the stock market. By using advance/decline statistics, it gives overbought and oversold indications, divergences and measurements of the power of a move.

Every day that stocks are traded, financial publications list the number of stocks that closed higher (advances) and the number that closed lower (declines). The running cumulative total of daily breadth is known as the Daily Advance/Decline Line. This is important as it shows great correlation to the movements of the stock market, and because it gives us another way to quantify the movements of the market other than looking at the prices of Indices.

The second chart shows an example of the Daily Breadth. Each tick mark represents one day’s reading of advances minus declines. In order to better identify the trend that is taking place in the daily breadth, we smooth the data by using a special type of calculation known as an Exponential Moving Average (EMA). It works by weighting the most recent data more heavily and older data progressively less. The amount of weighting given to the more recent data is known as the smoothing constant.

We use two different EMA’s, one with a 10% smoothing constant, and one with a 5% smoothing constant. These are known as the 10% Trend and the 5% Trend for brevity according to the tradition established by the late P.N. Haurlan who first used EMA’s for tracking the stock market in the 1960’s. The numerical difference between these two EMA’s is the value of the McClellan Oscillator.

The MO offers many types of structures for interpretation, but there are two main ones. First, when the Oscillator is positive, it generally portrays money coming into the market. Conversely when the Oscillator is negative, it reflects money leaving the market. Second, when the Oscillator reaches extreme readings, it can reflect an overbought or oversold condition.

From my experience of using the McClellan Oscillator over the last 15 years a reading at +250 portrays the market as extremely overbought, while a reading with a value of -250 indicates an extremely oversold market. For example in November 2012 the MO showed a reading of -325 which led to a 20% rally in the stock market over the next few months.

Now to get the full benefit of the MO we have to use this indicator in conjunction with the Daily Bollinger Band and Williams Index.

Below is a brief explanation of both of these key indicators.

Bollinger Bands

The Bollinger Band indicator is a channel (two lines) that surround the price action of a stock or traded instrument and allows you to see overbought and oversold conditions easier. The lines are constructed using two simple moving averages with 2 standard deviations applied. By applying the standard deviations, it improves the reliability of the moving average channel impressively. In fact, it usually ensures that at least 95% of price is enclosed in the channel. Don’t worry too much about settings or the logic behind the indicator, just start off with the default setting on your trading platform and go from there.

They are most effective during a consolidation or sideways price action and in such situations these bands will define, in a graphical manner, the support or resistance levels in whatever instrument you are tracking, be it stocks, indices, commodities or currencies.

The chart below illustrates the overbought and oversold levels on the September Mini S&P Futures Contract.

Bollinger Band Study

As you can see, for the most part the price action is centred in around the centre ‘brown’ moving average line however on occasions it either breaks up to the top ‘purple’ line indicating overbought conditions or breaks down to the ‘blue’ oversold line. I have indicated a few examples of each using the arrows.

Trading with Bollinger Bands

The assumption when looking at Bollinger Bands, as verified by the above example, is that the price always wants to return to the middle line. So when it moves up to the overbought or down to the oversold lines it is reasonable to expect that there will be a ‘bounce’ off either extreme bringing the price back towards the middle. It is in these extreme situations that the trading opportunity exists.

Note of Caution

However, like all indicators, they should never be used in isolation, hence the fact that I would always look to verify the overbought and oversold situations by checking the Williams Index (Williams% R).

Williams Index (Williams %R)

Williams %R is a version of Stochastic, a momentum oscillator indicator that has been around since 1973. Like the Bollinger Bands, oscillators work best and were written for sideways trending or trading range markets and were primarily designed to track either overbought or oversold price conditions.

Typically, Williams %R is calculated using 14 periods and can be used on intraday, daily, weekly or monthly data. The time frame and number of periods will likely vary according to desired sensitivity and the characteristics of the individual security.

The scale ranges from 0 to -100 with readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold.

In the chart below I have overlaid the Williams %R onto the September Mini S&P Futures Contract Chart from above:

Bollinger Band and Williams %R Studies

I have also drawn horizontal lines at the -20 mark and the -80 mark. As you can see, in each of the cases identified as either overbought or oversold by the Bollinger Bands, the Williams %R has confirmed the reading and would give a lot of confidence to taking a reversal trade. However in the last oversold situation, as recently as last week, the Bollinger Band suggested an oversold situation but it wasn’t confirmed by the Williams %R dipping down to breach the -80 level – in that case, without the double confirmation, we would leave it alone.

When the stock market is oversold, and for example the S&P is trading outside the bottom of its Daily Bollinger Band, while at the same time the Williams Index has a reading at or near 100, we are on the lookout for a buying opportunity.

This is where the McClellan Oscillator comes in. We need to see the MO with a negative reading of greater than -250 and preferably closer to -300 (this happened twice already this year) as you can see from the daily chart below. The first buy signal in February at 1809 led to a rally just shy of 2100. The second one occurred on June 27 following the Brexit vote when the S&P hit at 1989 low before having another huge rally to the recent 2195 high in early August. In my opinion, when the MO is set up correctly with both the Daily Bollinger Band and Williams Index, it sets up a fantastic buying opportunity for at least a 10% rally.

SUMMARY

In summary, the way that I use these indicators is as follows:

  1. I review the Bollinger Bands on the various markets that I follow on a regular basis (every few days is sufficient given I am working off daily charts) to see if any are moving into the overbought or oversold areas.
     
  2. For those that are identified as clear examples I check the Williams %R Indicator to see of the extreme conditions are confirmed.
     
  3. I then consider the risk-reward in the trade by checking the difference between the overbought/oversold line and the middle moving average line. If there is a big enough gap (assuming that the price only wants to move from the extreme back into the middle) then I will put on the ‘bounce’ trade.

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About the author

Bryan Noble

Bryan Noble has been a futures trader over 30 years now. He began his career with Banque Nationale de Paris (now BNP Paribas) where he was in charge of the Off Balance Sheet Trading Desk for 12 years, followed by a stint with Ulster Bank Markets.

In 1995 he set up a floor trading business in FINEX, a trading floor division of the New York Cotton Exchange in the fledging IFSC in Dublin. When FINEX closed, a few years back, he continued to trade his own account which he still does till today.

In May 2010 he joined IIFT where he lectured for three years before leaving to concentrate on his own economic commentary TraderNoble.com, which he started in February 2012. This blog has now posted over 1200 daily commentaries and gives an insight into the buying and selling of nine individual markets on a daily basis.

Trading, like any other profession, requires a lot of self-education, adherence to some fundamental principles and continuous research. That is what Bryan Noble strives to provide with his TraderNoble.com site- a place to teach you, the active trader, something of his extensive knowledge of the markets.

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